Arguing About Money

What is a currency war, and how do you win one?

The finance ministers of the world’s largest economies are in the middle of one of their regular gatherings, and to no one’s surprise, they’re arguing about money. Specifically, they are talking about exchange rates, and tensions are running high. The Economist’s latest cover features fearsome-looking bank notes, shaped into paper planes, whizzing at one another under the banner “Currency Wars.” And the overseas edition of the People’s Daily, a mouthpiece of China’s Communist Party, warns that the United States has sparked a conflict that promises to retard global economic growth.

But what is a currency war, and is the United States in one? If so, how will we know who won?

A “currency war” is just a headline writer’s term for what economists describe as “competitive devaluation.” It’s helpful, in this context, to think of a dollar or a euro—any currency, really—as just another product: Its value goes up and down according to market forces. At any given time, any given currency exists in a global market determined by supply (how much of a currency exists) and demand (how much investors want to buy goods and assets denominated in that currency).

A country can make its goods and services “cheaper” in the global market—or, if you prefer, “more competitive” in the global market—by devaluing its currency. And it can devalue its currency in a number of ways, from printing more money (the greater the supply of its own currency, the less valuable it tends to be) to buying another country’s debt (the greater the demand for another country’s currency, the more valuable it tends to be). When a country’s currency falls in value, its exports usually grow, because its goods and services are cheaper on the global market.

So what’s happening now? The United States sparked the current “currency war” by telling China in September that it needs to let the yuan appreciate in value and by announcing its intention to let the dollar slide. In early September, Treasury Secretary Timothy Geithner ruffled feathers in Beijing by criticizing China’s manipulation of the yuan, which is worth less than it would be if the Chinese did not buy billions of dollars of U.S. debt. “Frankly, [the Chinese] haven’t let the currency move very much so far,” Geithner told Bloomberg News. “I think we’d like to see them move more quickly.” Then, Congress passed a mostly symbolic resolution threatening tariffs against Beijing. On top of that, earlier this month, the Federal Reserve announced its “quantitative easing” policy—printing possibly a trillion new dollars, thereby further eroding the value of the dollar.

Those actions, and general market tides, have pushed the value of the dollar down relative to other currencies in recent weeks. And that has created a lot of angst in other central banks and capitals. Export-reliant Brazil and South Korea, for instance, have already intervened to prevent their currencies from appreciating quickly against the dollar. To stop the Brazilian real from appreciating any further against the dollar, for instance, Brazil doubled a tax on foreign investors buying real-denominated debt and went to the marketplace to pick up dollars.

Given the slow recovery in the United States—the high unemployment, the lack of investment, the sluggish growth—policymakers have plenty of reasons to want to devalue the dollar and boost exports. The problem is that other countries are suffering the lingering effects of the global downturn, too. Every country would like its currency to be worth a little less, so that it can export more and boost growth. And no country wants to be on the receiving end of another country’s competitive devaluation, watching its exports dwindle due to another central bank’s machinations.

That is why, when one country decides to devalue, it only works for so long. Other countries can counter the effect of one country devaluing its currency easily—most often, by slapping tariffs on that country’s goods or, sometimes, by printing more of their own currency. The result: Nobody really wins in a currency war. A round of global competitive currency devaluation does not aid any country in the long term. It just ends up increasing the global money supply.

To quell the tensions among the financial leaders gathered in Gyeongju, the United States proposed not currency manipulations, but caps on trade surpluses and deficits. Geithner—who has repeatedly asserted that the United States is not trying to drive the dollar down and that it is not in a currency war—suggested that by 2015 all of the G-20 countries bring net exports and imports within 4 percent of GDP. (Currently, China’s surplus-to-GDP ratio is 4.7 percent, and Germany’s is 6.1 percent.)

Whether the other 19 leaders are ready to give up their bellicose language abut exchange rates remains to be seen. In any case, even if they are, it may be that talk about a currency war will be replaced by rumblings of a trade war.